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Does anyone how banks determine the spread over LIBOR on a Equity Swap?

Example:

Party A pays the return on SPTR to Party B

Party B pays 1M LIBOR + 40 bps to Party A

Does anyone know how the 40 bps spread would be determined?

Thank you!

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I realize the previous answer doesn't answer anything, yes the spread over LIBOR on the swap is such that the swap has 0 value at inception, but how do you compute the value of the equity leg ?

The spread on an equity swap depends on the level at which you can repo the underlying equity if you replicate the swap through a buy and sell transaction + a stock loan (its slightly different due to the regulatory treatment, a stock loan is on the balance sheet whereas a swap is not).

A swap from the "equity payer" perspective is the same as borrowing the stock, then shorting it. From the "equity receiver" perspective it is buying the stock and lending it.

The spread level will depend on this implicit lending/borrowing transaction terms :

  • Is the transaction breakable before its end or not, with which notice period ?
  • What is the term (duration of the transaction) ?
  • What is the collateral (independent amount) level arranged, in which currency ?
  • The repo itself (how hard is it to borrow the security) ?
  • Additional considerations such as cross-currency basis if the financing currency is different from the underlying currency, etc.
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Unless the counterparty specifically bought the swap, then at inception the swap had a 0 value, i.e. the spread is that value which equates the two legs. Of course, it's usually bumped up (bank receiving) or down (bank paying) as the trader's profit.

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The spread is determined by how much the notional value of the swap is collateralized. If the swap is 0% collateralized, your rate can be as high as L+600. If it's fully collateralized, as low as L+50.

If you keep 10% of the notional amount as pledged collateral, then any single day loss over 10% in SPTR would require additional margin to be posted above the collateral pool. The spread is a function of the credit-worthiness of the counterparty, the notional amount, the percentage of pledged collateral, and the assumed distribution of returns on the swapped instrument.

None of this walks through the exact method, and the ranges on the spreads of LIBOR are neighborhood figures, but that is how they approach it.

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